JB Certificates on the 3Y Interest Rate in EUR/USD - An efficient instrument to hedge bonds and lombard loans against rising interest rates

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JB Certificates on the 3Y Interest Rate in EUR/USD - An efficient instrument to hedge bonds and lombard loans against rising interest rates
JB Certificates on the 3Y Interest Rate in EUR/USD
An efficient instrument to hedge bonds and lombard loans
against rising interest rates

  Zurich, February 2012

      Only for distribution in Switzerland
JB Certificates on the 3Y Interest Rate in EUR/USD - An efficient instrument to hedge bonds and lombard loans against rising interest rates
Why to hedge a bondportfolio or lombard loan against rising
interest rates?
    Interest rates are still at very low levels

    Market expects that central banks will not increase short term rates in the next 2-3 years, but…..

    … a sudden change in economic datas or a change in market behaviour could cause a market
    shock in interest rates and lift up interest rates fast (= fear that central banks might increase short
    term rates sooner than expected)

    Bonds with a duration of 3-5 would sharply fall in price

    3 Years EUR Rate is 0.6570% p.a. and 3 Months Euribor is 0.15% = Spread only 0.5070%

    3 Years USD Rate is 0.6130% p.a. and 3 Months Libor is 0.30% = Spread only 0.3130%

    The compensation to hold an interest rate risk for 3 years is not compensated enough

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JB Certificates on the 3Y Interest Rate in EUR/USD - An efficient instrument to hedge bonds and lombard loans against rising interest rates
A bond has 3 embedded risks

                                                                                             Treasury Yield              Swap                  Yield Bond
    4.5

     4

    3.5

     3

    2.5
                                                                                                                                   Asset Swap Spread
     2
                                                                                                                                                        Swap Spread
    1.5

     1

    0.5

     0

1. Interest Rate Risk                                 2. Credit Risk                                          3. Liquidity Risk

Hedged with Interest Rate Swap = Asset Swap           Hedge with Credit Default Swap = CDS                    No Hedge possible!

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JB Certificates on the 3Y Interest Rate in EUR/USD - An efficient instrument to hedge bonds and lombard loans against rising interest rates
Basics:
Hedging interest rate risks with an interest
rate swap (IRS)

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JB Certificates on the 3Y Interest Rate in EUR/USD - An efficient instrument to hedge bonds and lombard loans against rising interest rates
A Swap (Payers) reduces interest rate risk

                                                              Swap (engl.) = exchange
                                                              Derivative contract between 2 parties
                                                              Exchange of a fix payment versus a floating payment
                                                              Predefined maturity
           A „pays“ fix interest                              No exchange of Nominal! Only interest payment

                                                            Example
Bank A                                             Bank B     Bank A pays „fix“ and receives floating payment
                                                              At trade the pv of the floating is equal to the pv of
                                                              fix payments
                                                              If the sum of all received floating payments is higher
         B „pays“ floating interest
                                                              than the fix payments Bank A makes a profit
                                                              So Bank A expectes higher rates and Bank B lower
                                                              rates

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JB Certificates on the 3Y Interest Rate in EUR/USD - An efficient instrument to hedge bonds and lombard loans against rising interest rates
Summary: Interest Rate Swap

    Advantages:

     Client is not exposed to interest rate risks anymore

     Very liquid hedging instrument

     Very efficient to change interest rate duration

    Disadvantages:

     A plain vanilla swap requires a minimum volume of 2-3 mio.

     Additional documentation is needed

     Cash flows need to be monitored

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JB Certificates on the 3Y Interest Rate in EUR/USD - An efficient instrument to hedge bonds and lombard loans against rising interest rates
JB Certificates on the 3Y Interest Rate
in EUR/USD

7
JB Certificates on the 3Y Interest Rate in EUR/USD

                                          Solution Securitization:

                                             Certificates are securitzed interest rates swap

                                             Pricing of certificates at launch - very simple - just the value of the 3 Years
                                             EUR or USD Interest Rate (EUR 1.97 = 3 x 0.657 p.a, USD 1.84 = 3 x 0.613
                                             p.a.)
                                             No stop loss in the product

                                             Hedge already possible for EUR 100 or USD 100

                                             No documentation needed - Listed on SIX - Exchange

                                             No additional margins, no margin calls

                                             All cashflows are priced into the certificate

                                             Clients does not have to monitor cashflows

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JB Certificates on the 3Y Interest Rate in EUR/USD

                                                          3 – Years EUR Rate                      3 – Years USD Rate

    Issuer                                                Bank Julius Baer & Co. Ltd., Guernsey   Bank Julius Baer & Co. Ltd., Guernsey

    Maturity Date                                         11.03.2016                              11.03.2016

    Nominal / Ratio                                       EUR 1.00 / 100                          USD 1.00 / 100

    Issue Price                                           EUR 1.97 (=0.657% p.a.)                 USD 1.84 (=0.6130% p.a.)

    Stop Loss Limite                                      No                                      No

    Valor/ISIN/Symbol                                     20.230.236 / CH0202302367 / JFPLT       20.230.237 / CH0202302375 / JFQJZ

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Hedging a EUR Bondportfolio

           Yield 1.20% p.a.              Pays fix 0.657% p.a.                Bondportfolio:                       10 Mio. EUR
                                        (or 1.97% for 3 years)
                                                                             Mod. Duration:                       3.00 years
                                        Floating 3 Months
                                                                             Average Yield                        1.20% p.a.
                                              Euribor                        3 Years Swap EUR                     0.657% p.a.
Bondportfolio                  Client                           JB           Price Certificate in EUR:            1.97 (3 x 0.657%)
                                                             Certificate     Asset swap:                          0.543% p.a.

                                                                             0.543% p.a. = Average Yield 1.20% p.a. – Swap 0.657% p.a.

Summary:                                                                   After Hedge:
Client exchanged his 3 years fixed Bondportfolio into                      Interest Rate Duration:                0.25 years
a 3 years floating rate portfolio which pays now:                          Credit Duration:                       3 years
 3 Months Euribor + 0.543% p.a. (= Asset Swap)

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Hedging a lombard loan linked to 3M Euribor

                                                                                Example:
               3 Months Euribor floating payments + 0.75% margin                  Client has a EUR lombard loan

                                                                                  He pays 3M Euribor (floating) plus margin of 0.75% p.a.

Lombard Loan                                                          Client      If interest rates are rising the clients interest
                                                                                  payments are rising as well

                                                                                Summary after hedge:
                                             Pays fix 0.657% p.a.                 Client cannot benefit anymore from lower rates BUT
                                            (or 1.9700 for 3 years)               now he knows his interest payments for the next 3 years

                                                                                  No interest rate risk anymore, no more leverage risk
Lombard Loan
                                   Client                            JB
                 Floating:                          Floating :
                                                                  Certificate     Client has a fixed term loan with for 3 years and pays
      3M Euribor + 0.75% p.a. margin               3M Euribor                     0.6570% p.a. + 0.75% p.a. = 1.4075% p.a.

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How many certificates do I need to buy to hedge my
bondportfolio?

 Formula:                                           Example how to hedge:                         Cost and Leverage:
                                                       Bondportfolio: EUR 1’000’000
                                                       Duration: 3.10 / Yield 1.20%                 Price 1 Certificate : 1.9700
                                                       Remaing years certificate: 3 years           Cost of Hedge:
     (Market Value Bondportfolio or Loan *             Nominal Zertifikat: EUR 1.00                 10‘333 * 1.9700 = EUR 20‘356
               Hedging period)                         Ratio: 100                                   Cost of Hedge in Percentage of Bondportfolio
                                                       Number of Certificates                       EUR 20‘356 / EUR 1‘000‘000 = 2.04%
     (Nominal Certificate* Ratio * Years to         (1’000’000 * 3.10)                              (=Equal to a leverage of 49X)
           maturity of Certificate)                                       = 10‘333 Certificates
                                                       (1 * 100 * 3)

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Hedge Bondportfolio - Scenario Analysis

 Immediate Interest Rate Change                                   Bondportfolio          Value Certificate    P&L Hedge     Combined in EUR
 -   1.00%                                                +3.00%/ EUR +31‘000                        0.00     EUR- 20‘356          +10‘643*
 -   0.50%                                                +1.50%/ EUR +15‘500                        0.72     EUR- 15‘500           +8‘060*
 +/- 0.00%                                                                 0.00%                     1.97       EUR 0.00                  0
 + 0.50%                                                  -1.50%/ EUR – 15‘500                       2.47    EUR + 15‘500                 0
 + 1.00%                                                   -3.00% / EUR -31‘000                      4.97    EUR + 31‘000                 0

 At maturity after 3 Years:
 3M Euribor average fixing rate                                   Bondportfolio          Value Certificate    P&L Hedge     Combined in EUR
 -   1.00%                                                           EUR 37‘200                      0.00    EUR- 20‘356           +16‘844**
 -   0.50%                                                           EUR 37‘200                      0.00    EUR- 20‘356           +16‘844**
     0.00%                                                           EUR 37‘200                      0.00    EUR -20‘356           +16‘844**
 + 0.657%                                                            EUR 37‘200                      1.97    EUR+ /- 0.00          +37‘200**
 + 1.00%                                                             EUR 37‘200                      3.00    EUR +10‘643           +47‘843**
 + 2.00%                                                             EUR 37‘200                      4.00    EUR +20‘976           +58‘176**

* The product cannot fall below the value of 0 in case of negative rates (positive convexity)
 ** Equal to an average 3M Euribor Rate + Asset Swap of 0.5430% p.a.

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Listing on the SIX – Swiss Exchange

                                                                                      Investor (internal or external) is independent of his bank,
                                                                                      he can hedge his interest rate exposure via a listed product

          Foating LIBOR or EURIBOR                     Fixed Rate                     Investor can do a hedge with a securitized swap
                                                                                      he normally could only do if nominal is higher than
                     LIBOR or
                EURIBOR based Loan                                                    2 Mio.

Investors‘s Bank                        Investor                          Long        Full flexibility, always fair value and real time pricing on SIX
                                                                        Leverage
                                                                        Certificate   At what interest rate do I enter into the hedge?

           Loss if rates are rising                Profi if rates are rising          Example.

                                                                                      Price 1.97, Maturity 3.00 = 0.6570% (1.97/3.00)
          Profit if rates are sinking               Loss if are sinking
                                                                                      Price 1.40 Maturity 2.40 = 0.5830% (1.40/2.40)

                                                                                      Price 2.50 Maturity 2.40 = 1.0420% (2.50/2.40)

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Summary - JB Certificates on the 3Y Interest Rate in EUR/USD

     Advantages:
       Very simple product to hedge interest rate exposure for 3 years

       No documention needed

       Listed on SIX Swiss Exchange, very liquid secondary market

       Certificates pay the sum of all 3M Euribor in EUR certificate or 3M Libor in USD certificate fixing

       If rates are rising full hedged, if rates are sinking close to 0 or below benefit of positive convexity

     Disadvantages:
       Client / Investor gives up potential that interest rates (resp. Euribor or Libor Rates) will stay low for
       next 3 years

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Legal Disclaimer (1/2)

Important legal information

This publication constitutes marketing material and is not the result of independent financial research. Therefore the legal requirements regarding the independence of financial research
do not apply.
The information and opinions expressed in this publication were produced by Bank Julius Baer & Co. Ltd., Zurich, as of the date of writing and are subject to change without notice. This publication
is intended for information purposes only and does not constitute an offer or an invitation by, or on behalf of, Julius Baer to make any investments. Opinions and comments of the authors reflect
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The investment as well as its performance are therefore exposed to currency fluctuations and may increase or decrease in value.

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© Julius Baer Group, 2013

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